The EU’s Political Integration Dilemma

As Germany and France look to contain a mushrooming sovereign debt crisis, the eurozone will have to consider greater political integration or face a crumbling of the common currency zone, says EU expert Daniela Schwarzer.

To help readers better understand the nuances of foreign policy, CFR staff writers and Consulting Editor Bernard Gwertzman conduct in-depth interviews with a wide range of international experts, as well as newsmakers.

German Chancellor Angela Merkel and French President Nicolas Sarkozy are meeting in Paris August 16 for yet another eurozone summit (Guardian) amid growing fears over sovereign debt contagion to Italy and Spain. But while Germany has supported the European Central Bank’s (ECB) reactivated government bond-buying program (Reuters), it has resisted calls for further EU political integration, adamantly opposing common eurozone government bonds (DeutscheWelle). The eurozone is approaching a crossroads between two political options, says Dr. Daniela Schwarzer, a European integration expert at the German Institute for International and Security Affairs. "One is that Europe leaps forward in terms of political integration," she says. "The alternative is an end to the currency union as we have constructed it over the last twelve years."

Is the ECB’s renewed bond-buying program enough to stem sovereign debt contagion to Italy and Spain?

In order to stabilize Italy and Spain, [the ECB] will have to work with very different volumes than what it is [doing] so far in terms of bond purchasing. The second critical factor is political backing from the eurozone member governments, in particular Germany. The whole idea of the bond-purchasing program really is to recreate credibility and willingness among market actors to get invested in those bonds in the medium term. It’s really crucial that Germany continues to silently back the ECB and not contradict it.

Will the austerity measures being implemented by Italy and Spain be enough to combat the debt contagion?

Italy has really restarted in the recent weeks a debate on austerity measures, but also on structural reforms. There are lots of problems which weigh heavily on Italy’s competitiveness, for instance labor market inflexibilities. So for both countries we are only seeing the start of a whole reform agenda that has to be defined. On top of that, Spain obviously has to solve its banking crisis. No, I don’t think what is being done will be the end of the story. In particular, if one of the countries asks for help from the EU or the IMF, there will be, of course, a conditionality attached to the loans, and there we will see a very explicit and externally imposed reform agenda.

Given the size of those countries, the European partners would prefer a situation where [a bailout is] not necessary. One of the reasons why the ECB is enacting--with the obvious silent backing of the eurozone governments--the bond-purchasing program is to prevent markets from driving either country into a situation where it cannot refinance itself on the markets.

One of the reasons why the ECB is enacting the bond-purchasing program is to prevent markets from driving Italy and Spain into a situation where either country cannot refinance itself on the markets.

What does the debt crisis mean for the fate of the single currency zone?

We are moving toward a moment of truth, where there are basically two political options. One is that Europe leaps forward in terms of political integration. The alternative is possibly an end to the currency union as we have constructed it over the last twelve years. If Europe does not manage to cope with the sovereign debt crisis, the cost of remaining in the currency for some countries may develop in a way that they find it, possibly in the short term, more interesting to leave than to stay within the currency union. Politically, it’s no longer excluded that there may be a situation where a country sees more benefit from leaving than from staying in the currency union.

What hasn’t been done since the first decision on the Greek rescue package was taken last April [2010] is a broad and honest debate within the EU about where this takes us in terms of further integration. It was just hopping from one crisis management decision to the next. In parallel, the eurozone engaged in a governance reform process in terms of thinking about ways to prevent a future sovereign debt crisis, with the reform of the stability and growth pact. But fundamentally we haven’t touched on the question of what kind of political structures does a currency union need if we come to a point where national sovereignty in terms of economic and budgetary policies is more and more restricted.

Politically, it’s no longer excluded that there may be a situation where a country sees more benefit from leaving than from staying in the currency union.

One example: The German minister of the economy came [forward] with a proposal where he said that we need a kind of stability council for the eurozone, a group of experts who would assess our national economic and budgetary policies. [It would have] the capacity to decide on sanctions and to decide on whether a country should receive European funds, and in what form. That is a very technocratic view of economic policymaking. The next major issue we have to debate is whether that kind of technocratic approach to governing European economies is not reaching its limit. Imagine a member state is suddenly sanctioned by a kind of expert grouping; you would immediately have deep-running debates on legitimacy and national parliamentary authority over budgets. We need to face the debate [about whether] more policy coordination on the eurozone level requires a democratization of the [EU-wide] government mechanism.

Is last month’s July 21 agreement to expand the temporary European Financial Stability Fund (EFSF) a step in the right direction?

It won’t be sufficient to solve the debt crisis we are in at the moment. But it’s a substantial move forward because more money was put on the table, so it gets more politically sensitive--for instance, with the second package for Greece. The EFSF, the current stability mechanisms, have been enlarged to enable them to buy bonds on the secondary market. And that is a substantially new thing it can do. This will be also introduced into the new permanent rescue mechanism, the ESM [European Stability Mechanism], which is going to take over in 2013 from the EFSF. It is a move toward a stronger European debt crisis management mechanism.

We are reaching a critical point where the old approach of rules, sanctions, and targets [may not be] sufficient to make national policymakers behave according to what has been agreed upon as a good economic or fiscal policy. The EU runs more and more into problems of legitimacy if national parliaments will not agree to have that kind of interference from the EU level. It cannot be a technocratic approach in my view, which is why it has to be a more democratic process involving national parliaments and the European parliament--and possibly also finding a way to elect top politicians at the EU level. For instance, there is a proposal to have a European president who is directly elected. This will be the next debate we have, which is [about] involving more democratic elements in [EU] policy coordination.

We are reaching a critical point where the old approach of rules, sanctions, and targets [may not be] sufficient to make national policymakers behave according to what has been agreed upon as a good economic or fiscal policy.

What are the implications of the European sovereign debt crisis for the U.S. economy, and, conversely, what are the implications of the U.S. debt situation for Europe ?

The overall concern in Europe is the effect of a potential double-dip recession in the United States and what that would mean for the EU. It would obviously have negative effects on economic development in the eurozone, and that would be a particular problem in times of a debt crisis, where the debt to GDP ratio would then go up for those countries which were seriously affected. That is something, with regards to the southern European member states and Ireland, people are very much concerned about. The other issue that is always a concern for Europe is the role of U.S. monetary policy and quantitative easing, [the risk of] inflationary pressure that emerges, and what that would mean for the eurozone. And the euro-dollar exchange rate: A strong appreciation of the euro in response to a declining dollar would be an enormous problem in terms of competitiveness for the eurozone. It will touch those member states first that are deeply infected by the debt crisis, because almost all of those countries suffer from insufficient price competitiveness in world markets.

For the United States, it’s very much the same way around. If Europe does not cope, or is not able to cope, with the debt crisis, that could mean that we also run into a new recession--that we have serious trouble in the financial sector--which would spill into the United States. And the currency [issue] works the other way around. If the euro suddenly declines, there would be pressure on the U.S. dollar.

What are the implications of both debt crises for the global economic order?

Both the United States and Europe see very clearly that the trend of losing relative weight in comparison to other emerging economies is accelerating. The eurozone will be overtaken by China before next year in terms of share of world GDP. No one can ignore that the relative decline of the Europe and of the United States--meaning of the West--in comparison to other world regions is being accelerated by the way both economies will emerge from the debt crises, and by the future pressure on the economies by the debt levels. There is less money for investment, for innovative projects or education. This is precisely what we would need in order to remain competitive in the medium term. The awareness is really growing that the consequences of the debt crisis will accelerate the trend of losing relative economic weight and also political weight, the capacity to be a strong actor in security politics.

The latest recurrence of domestic protests in Iran stems from the country’s role in regional wars, combined with corruption and economic mismanagement. This discontent is likely to continue to pose a challenge.